Managing the Business Interest Expense Deduction Limit
Posted by Michē Needham on March 03, 2025
The Tax Cuts and Jobs Act (TCJA) introduced Section 163(j), which generally limits the deduction of business interest expenses, with certain exceptions. This change has significant implications for businesses with substantial interest expenses. Understanding and managing this limit is crucial to minimize its impact on your tax bill.
Understanding Section 163(j)
Unless your business is exempt, the maximum business interest deduction for a tax year is the sum of:
- 30% of your company's adjusted taxable income (ATI),
- Your company's business interest income, if any, and
- Your company's floor plan financing interest, if any.
For most companies, the deduction limitation is roughly equal to 30% of ATI. ATI is calculated as taxable income excluding nonbusiness income, gains, deductions, or losses, business interest income or expense, net operating loss deductions, and the 20% qualified business income deduction for pass-through entities. Notably, for tax years beginning after 2021, ATI is computed after subtracting depreciation, amortization, and depletion, which can reduce the allowable business interest deductions for companies with significant depreciable assets.
Carryforward of Disallowed Deductions
Deductions disallowed under Section 163(j) can be carried forward indefinitely and treated as business interest expenses in future tax years. The carryforward amount is applied as if incurred in the subsequent year, and the deduction limit for that year will determine how much of the disallowed interest can be deducted. Special rules apply to pass-through entities like partnerships, S corporations, and limited liability companies treated as partnerships for tax purposes.
Exemptions for Small Businesses
Small businesses are exempt from the business interest deduction limit if their average annual gross receipts for the preceding three tax years do not exceed a certain threshold. However, businesses treated as "tax shelters" are not eligible for this exemption. To prevent larger businesses from splitting into smaller entities to qualify for the exemption, related businesses must aggregate their gross receipts for threshold purposes.
Strategies to Manage the Deduction Limit
- Opting Out for Real Estate and Farming Businesses: Some real estate and farming businesses can opt out of the business interest deduction limit. However, this comes at a cost, as opting out requires using longer recovery periods for depreciation deductions on certain business properties. Businesses must weigh the tax benefits of unlimited interest deductions against the tax costs of lower depreciation deductions.
- Capitalizing Interest Expense: Capitalized interest is not treated as interest for the purposes of the Section 163(j) deduction limit. Businesses can capitalize certain overhead costs, including interest, related to the acquisition or production of property. Interest capitalized to equipment or other fixed assets can be recovered over time through depreciation, while interest capitalized to inventory can be deducted as part of the cost of goods sold.
- Reducing Interest Expense: Businesses can mitigate the impact of the deduction limit by reducing their interest expenses. Strategies include relying more on equity than debt to finance operations, paying down debts when possible, or generating interest income by extending credit to customers.
Future Considerations
The business interest deduction limitation is not scheduled to expire at the end of 2025, unlike many other provisions of the TCJA. However, there is a possibility that Congress could act to repeal or alleviate the limitation. Businesses affected by the deduction limit should stay informed about potential legislative changes and consult with tax professionals to assess the impact on their tax bills.
Conclusion
Managing the business interest expense deduction limit requires a thorough understanding of Section 163(j) and strategic planning. By exploring options such as opting out for certain businesses, capitalizing interest expenses, and reducing interest expenses, businesses can mitigate the impact of the deduction limit. Consulting with tax professionals can provide valuable insights and help determine the best strategies for your specific situation.
for more information
Michē has more than 21 years of experience providing tax and advisory services to commercial businesses and individuals. She has extensive experience with pass-through taxation of partnerships and S corporations and individual taxation, specializing in the areas of real estate, energy, and professional services. Additionally, Michē is responsible for providing services such as business tax planning, individual tax planning, personal wealth, and succession planning.